When people say the word “employment” they mean that they work for a living. That’s the colloquial definition. When people talk about their employer, they mean the person or company from which they derive income due to labor. However, these colloquialisms don’t necessarily correspond to the tax definition of what an employee is. This differentiation between employee and non-employee has bearing on the types of taxes that a worker is subject to, and is therefore an important distinction to make.
Employees versus Contractors
The IRS’s definition of employee is based primarily on the common law definition, under which the person or company who hired that worker has the right to control him or her. What matters here is not that the hiring party does in fact control the worker, but that the hiring party has the right to, under the terms of the job. In this context, if a person is not an employee, he or she is an independent contractor, and the hiring party cannot control the worker. Note that it does not matter how the worker is paid or what the worker is called. What matters is control or lack thereof by the hiring party.
What is control? According to the IRS, control falls into three categories: behavioral, financial, and relationship. Behavioral control is based on the hiring party directing the worker as to the specifics of his job in terms of the five Ws – when, where, who, why, and what – and additionally, how. Also, training the worker is a type of behavioral control that most likely is indicative of employment. The point is that the more specific the instructions and details in terms of how the worker behaves the more likely he or she is to be an employee.
Another type of control is financial. This practically means that the more the hiring party dictates the control of funds expended, paid, risked, or potentially realized in doing the job, the more likely the worker is to be an employee. For example, if a company allows a worker to invest heavily in a job through the purchase of expensive equipment, that worker is less likely to be an employee than a company who provides the equipment without an investment from the worker’s own funds. Also, if a company allows for a potential loss to the worker in performing the job, then the worker would almost certainly not be an employee due to the fact that employees almost never risk losing their own money as relates to employment. In other words, more financial control is exercised by the hiring party as to profit to the worker when the worker is an employee. Finally, if a worker is paid only after the job is completed, and that job takes several months, this would counsel against that worker being classified as an employee because employees are generally paid at least monthly by employers. The point is, look under the surface of the job to examine how costs, investment, and payment are handled in relation to the job done by the worker. Thereafter, critically analyze if that seems like more control on the part of the hiring party. In this context, the more financial control exercised by the hiring party, the more likely the worker is to be an employee.
The final type of control is found when examining the relationship between worker and hiring party. This can be thought of as the way that the worker interacts with the hiring party. Examples include contracts signed, benefits provided, the length of the working relationship, and whether the worker is providing a primary service that the hiring party is known for. You can imagine how this works. If a worker signs a contract indicating benefits and an indefinite period in which the worker/hiring party relationship may continue, along with outlining a primary core function of the business as the worker’s job description, then this arrangement would almost undoubtedly be an employee/employer relationship.
If a person is an employee, income tax along with social security and Medicare taxes have to be withheld from the employee’s paychecks and remitted by the employer directly to the IRS on behalf of that employee. Also in most cases the employer owes federal unemployment tax, under the Federal Unemployment Tax Act (FUTA), as well.
As a final note on the differentiation between employees and independent contractors, employees receive a Form W-2, Wage and Tax Statement, at the beginning of the year following a given tax year, which shows gross income earned, along with income, social security, and Medicare taxes withheld, among other employment-related qualitative and quantitative information. On the other side of the worker spectrum, independent contractors receive a Form 1099-MISC, Miscellaneous Income, which memorializes the amount of gross income earned, but generally does not have any income tax, or any other taxes, indicated as being withheld. Therefore, the contractor will be responsible for remitting the amount of income, social security, and Medicare taxes to the IRS on his or her own behalf.
Statutory employees are not employees under the common law definition and so therefore do not necessitate income taxes being withheld by the hiring party. As their name suggests they are considered employees under definition of statute, in other words, by fiat. However, in some instances these workers are considered employees for both social security and Medicare taxes.
Statutory employees are very specifically defined, and are described as follows: 1) agent drivers who deliver meat, vegetables, fruit, baked goods, beverages (but not milk), laundry, or dry cleaning; 2) insurance salesmen who sell for primarily one company; 3) a worker that is home-based but does work for a hiring party under its direction with material provided by and eventually returned to the hiring party; and 4) a salesperson who travels or is urban based and provides order taking services for customer’s in retail, wholesale, contractors, or operators of hotels, restaurants, and other enterprises in food or lodging.
These categories appear to be defined by a certain amount control exercised by the hiring party, but not enough to be considered a full-on employee for tax purposes. In this respect, this “half-status” requires withholding for social security and Medicare, under certain circumstances, but never for income taxes. The circumstances that require withholding for social security and Medicare taxes are: 1) the presence of a service contract indicating that the services underlying the job are to be performed either exclusively or primarily by the worker, himself; 2) the absence of significant investment by the worker in equipment used for the job; and 3) the job being done on a continual basis by the worker for the same hiring party.
To recap, the distinction between employee and contractor is generally one of degree. Also, if a worker is not an employee because there is not enough control exercised over him or her, then he or she is most likely an independent contractor, unless he or she is a statutory employee fitting a specified description under statute. Employees have income, social security, and Medicare taxes withheld by their employers on their behalf, while contractors almost never have any taxes withheld by their hiring parties. Statutory employees sometimes have social security and Medicare taxes withheld for them by their employers, but do not have income taxes withheld.
If you are having issues with determining whether your workers are employees, independent contractors, or statutory employees, don’t hesitate to call Dino Tax Co today at (713) 397-4678 or email firstname.lastname@example.org. The first phone consultation is always free. Also, like us on Facebook here.